Getting more bang for the regulatory buck is a constant challenge in the financial services industry, and Britain’s regulators are tackling the issue head-on with an in-depth assessment of the cost and the quality of their system.

The heavy expense of regulation is a major complaint in markets around the world. Britain’s Financial Services Authority and the FSA Practitioner Panel, a statutory body representing the industry, have responded by hiring Deloitte & Touche LLP to delve into the workings of the markets.

The firm found that the relatively light regulatory regime in Britain’s wholesale business had a competitive advantage, whereas its more intrusive retail regulations could be costly.

Deloitte’s study focused on three areas of the financial services business: corporate finance, institutional fund management and the “advice” sector. It surveyed a variety of firms in the industry, asking each to add up the cost of complying with every rule they must follow in the three sectors. The aim was to measure the incremental cost of regulation — expenses incurred on top of the cost of doing business in the absence of regulation.

In the corporate finance area, regulation was found to be a fairly minor source of added expenses above and beyond the infrastructure a firm needs to compete in the business. The incremental cost of each rule was found to be “significantly less than 1%” of a firm’s cost base. The survey also found the firms didn’t need to adopt many processes simply to satisfy regulators.

By far the biggest source of incremental regulatory cost in the corporate finance area was in human resources, keeping employees educated on the rules.

The second-biggest source of added cost was the direct fees paid to the regulator and other costs of managing the relationship. Together, the two tasks represented about 60% of the cost of complying with the rules.

As the survey tried to estimate the costs rule by rule, it didn’t produce an overall estimate of incremental regulatory cost for each sector, but it did report ranges.

In corporate finance, firms estimate that the regulatory burden represents between 0.5% and almost 5% of their total costs.

For institutional fund-management firms, the range spanned 0.5% to more than 7%. On the advice side, incremental regulatory cost ranged from about 2.5% of total costs to as much as 37%, with the median being about 12.5%.

The report says the relatively wide ranges reflect a number of differences between the firms surveyed, including their business model, efficiency and approach to risk. The estimates also probably overestimate the actual cost, it suggests, because the estimates were calculated by adding together incremental costs for individual rules, and there are probably overlapping areas.

Nevertheless, it is clear that on the advice side, incremental regulatory costs are much higher than they are for the wholesale parts of the industry. As with the other parts of the industry, direct fees and the chore of managing the relationship with the regulator accounts for about 25% of the cost. But the biggest source of regulatory expense is all of the little tasks essential to the business of providing advice. Chores such as determining suitability and fulfilling know-your-client obligations comprise about 40% of the incremental regulatory cost in the retail sector.

Another difference between retail and wholesale regulatory burdens is that, on the institutional side, cost tends to fall disproportionately on smaller firms. On the retail side, larger firms don’t have that scale advantage. The survey notes that both large and small firms in the retail advice sector report relatively high total incremental costs, and different-sized firms also account for those reporting relatively low costs.

In response to the survey, the financial services industry is pushing the FSA to reduce the regulatory burden in the retail sector.

Roy Leighton, chairman of the FSA Practitioner Panel, says the highly prescriptive rules in the retail sector are to blame for the relatively high costs. He has called on the FSA to eliminate rules whose costs are not justified by the benefits.

It is not clear whether any of the basic tenets of retail regulation could be dropped, but the FSA has indicated it plans a shift toward a more principles-based approach to regulation, which could relieve some of the burden.

Increasingly, principles-based regulation is touted as a possible solution to excessive regulatory burdens, and it has been the focus of a number of recent reform efforts in Canada. The B.C. Securities Commission sought to reduce its regulatory burden by shifting to a more principles-based approach, and securities regulators in both Ontario and Quebec are proposing to introduce a principles-based system in the derivatives sector.

@page_break@In late May, the Autorité des marchés financiers published a concept paper that proposes a new principles-based regulatory regime for the derivatives market in Quebec, noting that regulation based on core principles is more flexible and adaptable and, it suggests, would “reduce the regulatory burden, without affecting the quality of supervision.”

Taking a principles-based approach to the derivatives market, which is a largely institutional business, may be generally uncontroversial, but doing so in the retail sector is a tougher task. Although the industry is pushing for a reduced regulatory burden, investor advocates are less enthusiastic about the idea.

In Britain, the statutory body charged with defending investors’ interests to the regulator, the FSA Consumer Panel, has responded to the survey by stressing that the “benefits of financial services regulation must not be lost in the debate on costs.” It argues that regulatory costs are higher in the retail sector because this is where regulation is improving, and it needs to continue improving.

For its part, the FSA says, it is “determined to strike the right balance between discharging our statutory duties and avoiding unjustified costs.” It is planning to use the detailed rule-by-rule analysis of incremental costs set out in the study to shape regulatory reform.

John Tiner, the FSA’s CEO, notes that the authority will be looking at many of the staples of retail regulation to see whether they are warranted.

“The more significant costs appear to arise from providing point-of-sale documents to retail customers, monitoring employees’ compliance, handling complaints and reporting to the FSA,” Tiner notes. “We have an important program of work ahead to assess, with an open mind, whether these incremental costs are justified by the benefits and, if not, what changes we need to make.”

On the wholesale side, where the players are sophisticated and the market often provides the best discipline, less can be more when it comes to regulation. Any significant intervention can serve as a barrier to innovation and capital formation. Firms that behave unethically in the wholesale business can quickly find themselves frozen out of lucrative business or in court defending their actions, so there is plenty of incentive to play fairly.

The retail market is a very different animal. It is exceedingly rare that a retail investor is large enough or powerful enough to punish a firm that does it wrong. Clients are also often at a disadvantage with a company, because they may not have access to the quantity and quality of information that the firm does in any given transaction.

Moreover, most retail investors don’t have the resources to defend their interests in court effectively when something does go wrong. The basic power imbalance justifies a much more invasive regulatory system.

To make the playing field somewhat level between the industry and the individual investor, regulators are needed to prescribe disclosure requirements, force firms to adopt practices that will protect clients’ interests and prohibit behaviour that could hurt clients’ interests.

None of the rules, however, come without a price, and it is the clients who ultimately end up paying it. It remains to be seen whether the FSA can find a way to get more bang for all those bucks. IE